Bitcoin: The New ‘Inflation Hedge’?

Since it reached its peak in August 2020, gold prices have been constantly reaching lower highs and are down over 12% despite the rise in inflationary pressures. Investors seem to have lost interest in the precious metal, which has not been very sensitive to the dynamics of inflation in the past year.

On the other hand, Bitcoin has experienced a strong co-movement with the US 5Y breakeven; the rise in inflation expectations in the past two months has been associated with a strong rally in Bitcoin prices, from $40,000 to over $60,000.

The chart below shows that Bitcoin has been a better ‘inflation-hedge’ than gold in the past year, and therefore new highs in US breakevens could support the cryptocurrency in the near term.

One strong particularity of gold though is that it has historically performed well in periods of rising political uncertainty and price volatility (which has not been the case for Bitcoin). For instance, while gold was up 3.6% in the first quarter of 2020 when US equities plummeted by 20%, bitcoin experienced a 9% drawdown.

Source: Bloomberg, RR

AUD, GBP Most Undervalued In G10 World

In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.

AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.

The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.

On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.

Source: Bloomberg, RR calculations

The only chart that matters?

In the past few months, we have seen that despite the significant decrease in economic surprise indexes, US equities have constantly been reaching new all-time highs, with the SP500 index breaking above the 4,500 level this week. We previously saw that the US mega-cap growth stocks (i.e. FANGs) have been mainly driven by the dramatic surge in global liquidity, which we compute as the total assets of the major G10 central banks.

As the FANGs stocks represent a significant share of the SP500 index (over 25%), the strong momentum in tech stocks have pushed the whole index to new highs.

Interestingly, the chart below also shows the strong relationship between the Fed’s balance sheet assets and the SP500 in the past year. As a reminder, when the Fed halted its POMO operations in the end of October 2014 (following nearly a year of tapering), US equities remained flat for 18 months and experienced several drawdowns before starting to edge higher in H2 2016 with markets starting to price in further stimulus (Tax reform plan, higher spending). See the article entitled ‘Could we survive without QE?’ that we wrote in September 2014 for more details.

Even though this time is different, there is still a lot of uncertainty over the economic recovery, therefore normalizing policy too early could halt the momentum in US equities in 2022. This is a challenging time for US policymakers as inflationary pressures remain elevated in both DM and EM economies and the Fed needs to normalize its policy in order to leave more room for a potential new economic shock in the future. 

Source: Bloomberg

Is The Selloff Coming On Sterling?

We know that Sterling has historically traded like a risk-on currency that tends to appreciate in periods of trending markets and consolidate sharply in high-volatility regime.

Figure 1 shows the monthly average performance of the most liquid currencies relative to the dollar when the VIX rises above 20 in the past 30 years. As expected, the yen is the currency that benefits the most when price volatility rises, averaging 45bps in monthly returns. On the other hand,  the pound has averaged -30bps in monthly returns when the VIX was high.

Figure 1

Source: Bloomberg, RR calculations

This was confirmed during the March 2020 panic as GBP was sold aggressively during that month with Cable reaching a low of 1.14 (down from 1.32 in early March) before starting to recover gradually (lowest level since 1985).

Figure 2 shows an interesting relationship between GBPUSD and mega-cap growth stocks since 2020 (FANG+ stocks); Sterling has significantly recovered in the past 17 months, up nearly 20% against the US Dollar. However, the momentum on Cable has halted in recent months as risky assets have shown some signs of ‘fatigue’ amid rising uncertainty over a range of risk factors (i.e. Delta variant, falling growth expectations…).

Figure 2

Source: Bloomberg

A History of Interest Rates

Nominal yields on long-term government bonds have been constantly trending lower in the past 35 years, mainly driven by the lower global economic growth and the convenience yield for safety and liquidity. In addition, policy responses from both governments and central banks following the Great Financial Crisis have also contributed to the downtrend in LT interest rates globally, driving the term premium (investors’ compensation for holding interest rate risk) to negative levels.

Figure 1 represents the history of interest rates since the beginning of the 12th century up to today. The data source comes from Homer and Sylla’s book A History of Interest Rates (2005), which reviews interest rate trends in the major economies over four millennia of economic history. For the last 150 years, we compute a GDP-weighted average interest rate times series using a sample of 17 countries (Global LT interest Rate), using data from Jorda et al. paper The Rate of Return on Everything (2017).

One interesting observation was that in the past millennium, nominal interest rates have mainly traded below 10 percent, with two exceptions:

·         The first one is during the Spanish Netherlands period, which is the name for the Habsburg Netherlands ruled by the Spanish branch of the Habsburg. In the 16th century, Antwerp was one of the most important financial centres in the world, dominating international markets in sugar, spices and textiles. During a significant part of this century, the Exchange at Antwerp had dominated European transactions in bills of exchange and other credit instruments such as demand notes, deposit certificates and the bonds of states and towns (all short-term debts). Between 1508 and 1570 (when Antwerp defaulted on its debt), the interest rates were from loans by various bankers to the Spanish Netherlands government, Charles V and the city of Antwerp. We can notice that interest rates surged to 20% in the mid-1520s, and the bankers’ family, the Fuggers, made emergency loans to Charles V at annual rates as high as 24 to 52 per cent.

·         The second period of high interest rates was during the Great Inflation of the 1970s, which was marked by a sustained trend in inflation in the US that affected the rest of the World as well. A number of factors were associated to the rise in inflation during that decade: oil price shock following the 1973 embargo, speculation, avaricious union leaders and bad monetary policy management. As a consequence, long-term interest rates started to surge around the world, reaching a high of 14 per cent on average in 1981.

Interest rates globally are sitting at their lowest level in history, with the aggregate currently trading at around 0.5 per cent (probably trading between 1%-1.5% if we include some major EM economies to our times series of LT interest rates). As uncertainty has been constantly reaching new all-time highs (especially in the past year following the Covid19 shock) and growth expectations have been lowered accordingly, global yields have decreased dramatically since the last quarter of 2018 and broke below the lows reached in the late 16th century during the Republic of Genoa. At that time, Genoa became the banker for the Spanish Crown, a role previously held by German and Dutch bankers. The Bank of St. George was issuing placements or perpetual bonds called luoghi, which paid deferred dividends on the amount of taxes collected, after subtracting payment of the expenses of the bank.

The explanation of the persistence of very low real interest rates in advanced economies is a contentious issue. While many studies, including those by central bank research departments, stress secular forces such as demographics, over-indebtedness and dispersed income distributions – factors that emerged before the Great Financial Crisis – others find an important role for monetary policy in the determination of interest rates. On the secular view, a potential mean-reversion in long-term real interest rates must be driven by a global economic force such as a sustained period of above-trend economic growth. On the latter view, the monetary policy regime is endogenous to the real interest rate and the unconventional policies of the past decade are part of the explanation for low rates.

Figure 1. A History of Interest Rates

Source: Homer and Sylla, Jorda et al. (2017), Bloomberg, RR calculations

China ‘liquidity’ vs. Tech Stocks

In the past few months, we have seen that China Total Social Financing (TSF), a broader measure of credit and liquidity, has been falling sharply with the annual change in TSF 12-month sum down from over 10tr CNY in October 2020 to nearly 0 in May 2021. As a result, investors’ concern has been growing as they have been questioning if the rally we have observed in global asset prices can continue in the coming 6 to 12 months without Chinese help.

In the past cycle , periods of contraction in Chinese liquidity were usually associated with a fall in both domestic and international asset prices. This chart shows the striking co-movement between the annual change in China Tech stocks (CQQQ ETF) and the annual change in China TSF 12M sum. China Tech stocks are down over 25% since their mid-February highs; according to this chart, China tech stocks are expected to continue to consolidate in the short term.

Source: Bloomberg

Chinese ‘liquidity’ keeps contracting (Good news for US Bonds)

Since the start of the year, we have seen that the annual change in China Total Social Financing (TSF) 12 Sum has been shrinking rapidly, which could eventually become a problem for risky assets. Previous periods of sharp contraction in China TSF (i.e. 2018) have been associated with a sudden rise in risk-off assets such as USD or US Treasuries. Figure 1 shows that the annual change in China TSF 12M Sum fell from over 10tr CNY in October to 3.1tr CNY April.

Figure 1

Source: Bloomberg, RR calculations

Interestingly, we can notice that that a contraction in Chinese ‘liquidity’ has usually been followed by a fall in US long-term bond yields. For instance, figure 2 shows the 6M change in US 10Y Treasury yield with the 6M change in China 12M sum (8M lead). According to this chart, the consolidation the US 10Y yield has just begun.

Figure 2

Source: Bloomberg, RR calculations

Can the copper rally continue without Chinese ‘help’?

Copper was one of the major assets to benefit from the constant liquidity injections from central banks to prevent economies from falling into a deflationary depression. The front-month futures contract has more than doubled since its March low of 2.06 and is currently trading at 4.3, its highest level since August 2011.

However, we have also seen that copper prices (and other commodities heavily relying on Chinese economy) has been very sensitive to the annual change in China Total Social Financing (TSF). This chart shows that the annual change in China TSF 12M sum has been falling for the past 4 months, which has previously been associated with a correction in copper prices and other base metals. Can the momentum in copper continue without Chinese stimulus?

Source: Eikon Reuters

Great chart: USD index vs. 2Y10Y yield curve

As we mentioned it in one of our previous posts, there has been a strong co-movement between the US Dollar and the 2Y10Y yield curve in the past 15 years, but the relationship was potentially going to break out as the US dollar was getting extremely oversold while inflation expectations have been constantly rising in the past few months (usually leading to yield curve steepening). This chart shows that while the the USD index has stabilized at around 90-91 since the start of the year, the 2Y10Y yield curve has steepened sharply by 45bps to 1.25%.

Source: Eikon Reuters

Great chart: SP500 3Y change vs. unemployment rate

In the past year, central banks have been constantly injecting liquidity into the market in order to avoid the global economy from falling into a deflationary depression, which has generated a strong rebound in risky assets, especially mega-cap growth stocks. However, we previously discussed that the more liquidity reaches the market today, the harder the ‘COVID-19 exit’ will be. Equity markets have been diverging significantly from their ‘fundamental’ value in recent months and therefore a reversal in the stance of the Fed monetary policy could eventually result in a sharp selloff in US equities,  which could have a significant impact on the real economy. This chart shows the strong co-movement between the 3-year change in the equity market (SP500) and the annual change in the US unemployment rate in the past 50 years; periods of equity weakness have been historically associated with a higher unemployment rate.

It the real economy robust enough to swallow a sustain period of equity weakness in the medium term?

Source: Eikon Reuters